There is a legendary creature in Australian and British folklore that goes by the name of the Oozlum bird. One of the leading stories has the bird flying in ever-decreasing circles until it manages to fly up its own fundament. This behavior places our friend on a path to self-extinction. Other stories suggest that the bird flies backwards because while it does not know where it is going, it likes to know where it has been. The Oozlum bird is often used in literature as a symbol of "circular argumentation" and as such we have unofficially nominated this wonderful creature as the official bird and mascot of the Federal Reserve.
The Fed’s actions, results and communications over the past decade have shaken confidence in the institution to the point where its effectiveness and creditability are being seriously questioned. Has this traditional institution put itself on a path to extinction like the Oozlum? They have become the masters of doublespeak and the circular argument, leaving markets and investors deeply confused. In addition, neither the Fed nor the Oozlum seems to know where they’re going, and clearly the Fed has little interest in reviewing where it has been.
We believe the Fed has lost its way. Nothing it does in the foreseeable future will have any meaningful positive economic impact. It is tightening in the late stages of the business cycle with the economy limping along at under 2.0% growth and with inflation as measured by the PCE at 1.54% well under its stated objective of 2.0%. The capital markets have completely emasculated monetary policy makers and they have no one to blame but themselves. They raise rates and rates decline and the curve flattens. What’s missing is that savers and the real economy are spectators in this dysfunctional environment. Elementary economics suggests that a huge increase in the supply of money should have incited inflation. It hasn’t. Why? Simultaneous to this incredible shift in the supply has been a larger decrease in its velocity. That is, no one is spending for the aforementioned reasons - real folks are busting to save even more because they fear the low rates and low growth. Similarly, corporate strategists aren’t spending because they don’t see any potential ROI on capital expenditures.
The central assumption of all economic theory is rational decision making. So, policy makers have literally violated the basic tenet of the very theory they claim to be following. The consequences of this are profound. In the span of few years, they have managed to destroy the very basis for transparent efficient capital markets. In its place is literally a market that has deteriorated into a cliché - "never fight the Fed." We have always detested that term because it implies that deliberate, thoughtful, meaningful analysis is not necessary. Wall Street has added to this mess by rejecting historically accepted valuation methodologies and analysis.
What is next? What is the end game for policy makers? A June 2016 Fed staff working paper by David Reifschneider entitled "Gauging the Ability of the FOMC to Respond to Future Recessions" suggests that the Fed would find itself impotent to fight a recession that occurred during the next two years. The staff paper paints a scenario out in 2018-2019 of full employment, inflation at 2.0% and a funds rate at normal longer-term levels of 3.0% when a recession hits. Given the current state of the term structure, this starting scenario seems like fantasy. It gets better - Fed simulations suggest that large-scale asset purchases ($4 trillion QE program) and forward Fed funds guidance should be able to drive long-term rates substantially lower and "succeed in juicing the economy." Are these people suffering from "economic amnesia" or something more serious? Simulations are only as useful as the assumptions made to run them.
Where has unconventional monetary policy (quantitative easing, forward guidance/insuring rates stay at zero for longer than fundamentals dictate and currency manipulation in support of exports) worked or where is it working?
Remember the end goal of such policy is economic growth driven by artificially induced low interest rates and above intrinsic value equity valuations. We see no evidence that these policies have succeeded in their primary goal of generating economic growth; in fact, they have created new financial bubbles, larger debt burdens and lowered the credibility of central banks. The failure of these approaches to drive growth should not be in dispute. The question that should be asked is why do these failed polices continue to be contemplated?
In addition, these policies have failed in their secondary goal of putting upward pressure on inflation and inflationary expectations. There is no more evidence than in Japan where deflation seems deeply ingrained. Those arguing against the views expressed here employ the straw man argument that economically we would be worse off without the implementation of these policies. This paradoxical argument is merely a rationalization for those policy makers who have no accountability or those who are selling overvalued assets.
The reader may ask why is all this important? We are in a secular and global period of low economic growth without the tools to address the problem effectively. The United States is also facing a host of institutional roadblocks to economic vitality. They include the demographics of an aging population, a lack of skilled workers, enormous debt burdens, growing political division, a widening income gap, decaying infrastructure, no meaningful fiscal policy over the last 10 years and little prospects immerging from the current administration, a vulnerable equity market at bubble levels, and a Fed tightening for non-economic reasons in the latter stages of the business cycle. This is heavy stuff. Again, the Fed’s strategy was to lower interest rates to drive equity valuations higher on a comparative basis while increasing the (non-existent) wealth effect to spur economic growth. It did not work and will not work if employed in the near future. Investors should not expect a repeat of the equity experience of recent years. We all need a Fed that has learned from its mistakes.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.